(By Andrew Torres, guest contributor)
Junk bonds roared into the headlines this week after talk of fund liquidations triggered a panic selloff that rocked markets on Friday and Monday. Many are wondering if this is a sign of things to come as the Fed hikes interest rates this week for the first time in almost a decade.
US High Yield markets are on track for 2015 returns around -6%, which would be their worst year since 2008 (-17%). From 2009-2014, investors enjoyed average annual returns of 11%, so High Yield bonds can be attractive for those willing to tolerate occasional negative years. However, there is reason to be cautious in the next few years. As rates begin to normalize and lending standards are being tightened, it is reasonable to expect more defaults, particularly in the hard-hit commodities sector.
High Yield investors are compensated in the form of excess spread for various risks including defaults, reduced liquidity and negative convexity. The excess spread for High Yield has widened in 2015, from 500bp in May to over 700bp in December. As investors demand a wider spread, bond prices fall, causing valuation losses.
At 700bp are investors being adequately compensated?
These levels are reasonable, since default rates are expected to rise only moderately in 2016 (from 2% to 4%). Furthermore the liquidation issues we have seen in headlines this week have been fairly isolated to specialist funds with concentrated sector risks. But we expect generally more modest (mid-single digit) returns and periods of severe price swings which will become deeper and more frequent as the Fed withdraws stimulus and trade volumes continue to grow relative to the risk tolerance of market makers.
But do advisors need to take on that kind of risk for their clients?
Consider moving them to Investment Grade credit, where price volatility is typically 2% compared to 7% for High Yield. Alternative bond funds using Investment Grade Strategies target 5-7% returns, and have generally managed to deliver +3-4% in 2015 despite negative returns in High Yield and stocks. And similar to High Yield, the excess spread in Investment Grade has improved in recent months, which offers potential for higher returns in 2016.
Is it any wonder institutional investors devote significant components of their portfolios to Investment Grade credit, while High Yield tends to be primarily owned by individual investors?
As ever, it comes down to your client’s tolerance for risk.
Andrew Torres is the Founder and Chief Investment Officer for Lawrence Park Asset Management, an Alternative Fixed Income Manager based in Toronto. Andrew has been trading and investing in corporate bonds over a 25 year career that spans Toronto, New York and London. You can follow Andrew on Twitter: @TorresCredit